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Morningstar: Industry’s Idea of Clean Shares May Not Be Clean Enough

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Clean shares of mutual funds, the investment innovation designed to allow brokers and advisors to serve as level fee fiduciaries under the Labor Department’s conflict-of-interest rule, are expected to revolutionize how financial professionals are compensated and how their clients pay for services.

But before that can happen, regulators and industry are going to have to settle on exactly what constitutes a clean share.

Earlier this year, the Capital Group, owner of American Funds, requested and received guidance from the Securities and Exchange Commission for clean shares, which are packaged without front-load sales commissions and deferred 12b-1 distribution charges. In lieu of those commissions and fees, which have been traditionally set by asset managers, brokers and advisors are allowed to add on their own charge for advisory services on top of funds’ management costs.

The SEC’s no-action letter was widely perceived as green-lighting the issuance of clean shares.

But according to Paul Ellenbogen, head of global regulatory solutions for Morningstar, questions remain about the role of sub-transfer agency fees, charges traditionally embedded in mutual funds to cover the cost of record-keeping investors’ assets.

“It all comes down to a question of five or 10 basis points,” said Ellenbogen. “Our view would be that sub-TA fees render a share class not clean. Industry, for now, seems to be relying on an interpretation that makes American Funds F-2 shares clean. We would say they are not.”

American Funds’ F-2 shares are akin to institutional share class funds throughout the industry, explained Ellenbogen.

Prior to the fiduciary rule, American funds distributed F-2 shares to retail investors through fiduciary advisors that charged their own asset-based fee on top of the funds’ cost. They do not carry 12b-1 fees, which vary substantially across the universe of mutual funds, from 25 basis points to 100 basis points. Prior to the fiduciary rule, advisors and brokers faced a potential conflict of interest when recommending funds with higher 12b-1 fees.

The F-2 shares do, however, come with sub-transfer agency fees, channeling money to advisors’ firms when they assume the role of record-keeping assets in lieu of the Capital Group’s internal transfer agency.

According to American’s AMCAP fund prospectus, F-2 shares are subject to a sub TA fee of 12 basis points, and typically range from $3 to $19 per account.

“Multiply that out over decades and across industry and we’re talking about billions of dollars,” said Ellenbogen.

At the end of 2016, American Funds issued an F-3 share class that comes without 12b-1 fees or sub TA fees. According to the AMCAP fund prospectus, F-3 shares do carry 7 basis points in “other” costs to account for administrative services, on top of the 30 basis points in management fees.

“We would say the F-3 shares are clean,” said Ellenbogen. The problem from Morningstar’s perspective is that many are interpreting the F-2 shares as clean as well.

The question of whether sub-TA fees render a mutual fund unclean is more than nominal, particularly when Morningstar’s definition diverges from industry. Ellenbogen said Morningstar is in the process of establishing a platform that certifies clean shares. The Capital Group declined to comment for this story.

Under Morningstar’s definition of clean shares, record-keeping costs will have to be unwound from mutual funds, and either charged directly to the investor, or potentially absorbed by asset managers—meaning they would come out of fund companies’ profits.

Funds that refuse to absorb those costs would conceivably struggle to find distribution, said Ellenbogen.

Moreover, the prospect of reorganizing how investments are papered presents a massive operational challenge.

“Right now, most broker-dealers are not set up operationally and legally to take these clean shares. It means reengineering entire business models,” said Ellenbogen.

The extent of operational change needed to accommodate clean shares across industry can hardly be expected by January 1, 2018, when the fiduciary rule is scheduled for full implementation, and is one of the reasons why Morningstar expects the Labor Department to delay that date.


Clean shares the way of the future — with or without fiduciary rule

So far, only a handful of asset managers have made new filings for clean shares with the SEC—more a trickle from the pipeline than a flood.

Beyond the uncertainty of sub-TA fees, much of the delay in rollout can be chalked up to the circular process of the Labor Department’s review of the fiduciary rule.

Regulators have said they want to examine the impact of clean shares on the market as part of its assessment of the fiduciary rule.

As the Trump administration has telegraphed its intention to significantly revise the rule, fund companies have chosen to play the clean share card close to the chest, muting the rollout of more shares from more managers. Ellenbogen likens it to a game of chicken.

No matter what becomes of the rule, clean shares are here to stay, says John Faustino, chief product and strategy officer at Fi360, a fiduciary compliance firm.

“There are clearly significant operational challenges depending on how a broker dealer is set up—that is not a trivial task,” said Faustino.

“But ultimately clean shares will be the right thing for investors,” he added. “The general ambiguity with the fiduciary rule has created some tentativeness with asset managers, and while there may be some delays, ultimately market forces are going to drive asset managers to have to issue clean shares.”

That American Funds—branded on low-cost active management–positioned itself at the head of the line makes perfect sense, says Faustino.

“They have a great incentive to do it. Clean shares align with their message that active is not worse than passive,” he said.

Stripping 12-b1 fees and sub-TA fees from the F-3 shares, and putting the onus on brokers and advisors to charge what they will for advisory services and commissions, will make it easier for American Funds and other active managers to communicate value to investors, presuming strategies can beat indexed investments.

New challenges for brokers and advisors

Sans the fees, clean F-3 shares in the AMCAP fund, which seeks long-term growth through U.S. equities, will cost 37 basis points before advisory fees are charged. By comparison, investor shares of Vanguard’s Large-Cap Index Fund, which also has no 12b-1 fees, cost 18 basis points.

While clean shares can be expected to be embraced by more fund companies, they present new challenges for brokers and advisors.

“Clean shares force them to articulate their value proposition in a different way than they have,” said Faustino. “If you are providing value through fund selection and other services, your fees and commissions will be justified. The challenge will be for advisors that haven’t been adding value and taking the 12b-1 fees. With clean shares, it’s all about justifying your costs.”

Morningstar’s Ellenbogen says clean shares are the best representation of a fund’s performance.

While the firm has been a long proponent of both lower fund fees and what Ellenbogen calls the “substantial” value advisors can add for investors, figuring how to price different levels of individualized advice into clean shares remains an open questions.

“There are a lot of unknowns when it comes to getting a handle on the cost of advice and getting a sense of how people value it—clean shares will force those questions to be answered,” said Ellenbogen. “For some investors, personal advice will start to look expensive and unduly complicated.”

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